Risk Premium: LIFE WITHOUT LEVERAGE

For The Week Ended June 20, 2008

STOCKS TURN DECIDEDLY LOWER

Stocks closed at their lowest levels since March as worries about the financial sector continued to pressure both the stock and credit markets.  The Dow Jones Industrial Average finished at 11,842.69, down 464.66 points (3.78%) for the week.  Our Risk Premium model has pointed toward a decidedly negative stock market and we feel that a downward trend is firmly in place.

LIFE WITH LESS LEVERAGE

The central question facing the financial services group is: when will the write-offs end?  Some observers have argued that the worst was over and that the share prices of many companies that had finally cleaned up their balance sheets now offer attractive valuations.  We have continuously cautioned against this conclusion and feel that the valuation standards of the past decade may no longer be reliable guides at this particular time.  A P/E of 20x may be “normal” and 16x even “cheap” but the readjustment of risk parameters could undermine these historical benchmarks.

TOP-DOWN OR BOTTOM-UP?

The bottom in stock values and, in particular, financial service companies is elusive because investors are approaching valuations from the top down, that is, comparing stocks and P/E’s to recent highs.  We suggest that investors abandon this approach in favor of a bottom-up view, namely, looking at prices and multiples based on the “lows” experienced in recent years.

A NEW PARADIGM IN REALIZABLE RATES OF RETURN SUGGESTED

We strongly feel that investors should consider a paradigm change in the realizable “rates of return” which can be achieved in an economic environment where credit and the ability to leverage assets has been diminished – if not permanently at least for the foreseeable future.  For example, the ability to earn 20% or higher returns relied upon a financial environment in which leverage was easy and inexpensive.  Credit is clearly less available now and, therefore, the ability to leverage the purchase of assets, from housing to credit cards to synthetic financial products has been greatly altered.  As a result, expectations on returns must be lowered.

The ongoing turmoil in the financial services sector is a perfect illustration of this shift.  Is it realistic to assume that these companies can properly value their portfolios?  No.  The problem is that the underlying values of assets held are on a rollercoaster trajectory, making it extremely difficult to call a bottom.  Until the economy starts to show signs of stabilizing (we dare say, improvement), the reliability of asset valuations will remain “suspect.”  This state of affairs is widespread in the financial services sectors who, as intermediators, effectively serve as the ultimate reflectors of asset valuations.  In short, valuation standards need to be adjusted since the profitability achieved by leverage has been greatly diminished.

CHINA RELAXES FUEL SUBSIDIES-- ILLUSTRATES ITS MARKET MOVING MIGHT

The increasing demands of growing economies for energy resources have altered the pricing dynamics.  This was evidenced when China this week removed fuel subsidies.  Many observers hoped this would reduce China’s imports and relieve some of the upward pressure on oil prices.  The immediate reaction to the move was a $4.75 decline in crude oil prices, to $131.93 per barrel. The surge in oil imports by emerging economies illustrates the upward (and lasting) shift in demand by the growing global economy.

OIL PRICES: PRESSURE FUTURE CORPORATE PROFITABILITY

We expect that the volatility and persistent increase in the price of oil may subside during the next 12 months, perhaps heading down toward $100-$120 a barrel.  Our thinking is influenced by:

• Reduced Demand by the U.S. reflecting the weak economy in 2008
• Overtures by Saudi Arabia to ultimately increase production by 500,000 barrels per day (which is not overly meaningful when one considers that world-wide consumption is 86 million barrels per day)
• Investor speculation in oil may  subside as the perception that demand may slow due to economic forces in the immediate future and the Saudi’s commitment to expand supply
• Finally, expectations that the Federal Reserve will increase short-term interest rates, thereby strengthening the value of the U.S. dollar

CAN A DECLINE IN OIL PRICES BE SUSTAINED?

We propose that a retreat in oil prices, perhaps testing even the $100 per barrel level, is not viable in the long-term (12 or months) because declines in consumption by the U.S. and other weakening economies, will be displaced by economies having strong long-term growth prospects, notably China and India.  Moreover, the Saudi’s reluctance to provide “firm” statistics on oil reserves could be disruptive variable.

Accordingly, the profitability of corporate America will be impacted by this new world economic order.  Profit expectations (de facto rates of return) must account for the increasing expenses caused by rising energy prices. While they may rise and fall over the short term prices are significantly and permanently biased to the upside. It should therefore come as no great surprise that FedEx, a heavy fuel user, reported a $163 million fourth quarter operating loss, its first in more than a decade.

FINANCIAL SERVICES’ SECTOR RATTLES INVESTOR CONFIDENCE

Goldman Sachs’ second quarter earnings surpassed analyst expectations. That’s where the good news begins and ends.  The firm reported an 11% decline in profits, to $2.09billion, as positive performance in its prime brokerage and commodities businesses offset losses in other business divisions.  In a gloomy assessment Goldman noted that U.S. banks may require $65 billion in additional capital to shore up the sector, clearly dashing investor hopes that the credit crisis had reached bottom.

Morgan Stanley also released results for its fiscal second quarter ended May 31^st.  Revenues were down 38% and profits declined some 60%.  The firm managed to post a $1.03 billion profit (95 cents per share) after including a gain from the sale of its Spanish wealth management operations and NSCI Inc., its indexing business.  Net income was hurt by an array of charge-offs totaling $1.7 billion stemming from $496 million in leveraged loans, $390 million relating to bond insures, $300 million from Alt-A mortgages, $200 million from Private Equity transactions, $120 million associated with a Trading Irregularity and $86 million from Structured Investment Vehicles.  Morgan Stanley’s performance was especially disappointing because the investment community had hoped that under John Mack’s tutelage and the infusion of $5 billion from China that the worst was behind them.

Early in the week, Lehman Brothers posted a quarterly loss of $2.8 billion, essentially in line market expectations.  Lehman took a $3.7 billion of write-down during the quarter for assets including mortgage securities and considerable trading and hedging losses.

Citigroup added to the concerns of the financial services sector by announcing late in the week that its second quarter results would be adversely affected by a new round of “substantial” mortgage related write-offs.  Citigroup’s comments inflamed overall market concerns that the banking sector is and will continue to struggle with an ever weakening investment portfolio as the economy slows and defaults mount on loans to consumers and businesses.  Citi’s Chief Financial Officer noted that its business remains under pressure amid “unprecedented” market conditions.

MBIA AND AMBAC DOWNGRADED, AGAIN!

The financial sector faced yet another setback this week when the final shoe dropped on MBIA and Ambac which were downgraded this week by Moody’s to Single-A from Triple-A in one fell swoop, following similar downgrades by Standard  & Poor’s and Fitch Investor Services.  These downgrades are negative developments, especially for Citigroup, Merrill Lynch and UBS as well as for other financial intermediaries which could face additional asset write-downs because many of these institutions bought roughly $125 billion of insurance from the MBIA and Ambac, enabling these firms retain the value of risky assets backed by risky mortgages and other complex, synthetic structured securities.  As the ratings of these insurance hedges fall, the risk of additional underlying asset devaluations (i.e. write-offs) is heightened.

NO RELIEF IN SIGHT FOR THE FINANCIAL SECTOR

The negative sentiment was echoed by a report from Merrill Lynch, reiterating a bearish outlook for large and regional bank stocks, which cut the earnings estimates for 12 companies.  The report emphasized that increasing credit loss assumptions across nearly all consumer and commercial loan categories influenced its thinking. Growing delinquencies in the residential, construction and second-lien equity home loans are expected to result in higher credit loss estimates and rapidly rising non-performing assets.   The lower earnings estimates reflect a substantial  increase in additional loan loss reserves, for example, the report expects loans written off by the largest regional banks to rise to 1.14% of loans this year and 1.52% of loans next year, compared to just 0.38% in 2007.  Other industry analysts concurred that banks still need to substantially step up loss reserves.  The negative comments contributed to the NYSE Financial Sector Index taking a nosedive, initially falling by 118 points.

RISK PREMIUM STATISTICS

§         The Industrial Risk Premium ended at 1.25% versus 1.20%

§         The Transportation Risk Premium decreased to 4.12% from 4.43%

§         The Utility Risk Premium increased to 6.33% from 6.27% n

Continues ▼

Continues ▼

Continues ▼

For June 13th's Comment Please Click Here

For June 6th's Comment Please Click Here

For May 30th's Comment Please Click Here

For May 23rd's Comment Please Click Here

For May 16th's Comment Please Click Here

For May 9th's Comment Please Click Here

For May 2nd's Comment Please Click Here

For April 25th's Comment Please Click Here

For April 18th's Comment Please Click Here

For April 11th's Comment Please Click Here

For April 4th's Comment Please Click Here

For March 28th's Comment Please Click Here

For March 21st's Comment Please Click Here

For March 14th's Comment Please Click Here

For March 7th's Comment Please Click Here

For February 29th's Comment Please Click Here

For February 22nd's Comment Please Click Here

For February 15th's Comment Please Click Here

For February 8th's Comment Please Click Here

For February 1st's Comment Please Click Here

For January 25th's Comment Please Click Here

For January 18th's Comment Please Click Here

For January 11th's Comment Please Click Here

For January 4th's Comment Please Click Here

For December 28th's Comment Please Click Here

For December 21st's Comment Please Click Here

For December 14th's Comment Please Click Here

For December 7th's Comment Please Click Here

For November 30th's Comment Please Click Here

For November 23rd's Comment Please Click Here

For November 16th's Comment Please Click Here.

For Additional Information or Questions Please Contact Us.